Yet Another Controlling Shareholder Opinion

This week, I continue in my series of posts about controlling shareholders (prior posts here, here, here, here, here, here, here, here, here, and here) to call your attention to Patel v. Duncan, decided September 30.

Talos was a company backed by two private equity sponsors: Apollo and Riverstone. Apollo had 35% of the shares; Riverstone had 27%; and the rest were publicly traded.  Talos had a 10 member board, and Apollo and Riverstone had a shareholder agreement that guaranteed each would appoint 2 members, a fifth member would be jointly agreed upon, and the sixth member would be Talos’s CEO.  Of course, because their combined voting power exceeded 50%, there was no doubt their nominees would be included on the board.  As a result, the company’s SEC filings identified Talos as a “controlled company” for the purposes of NYSE rules; as the company put it, “We are controlled by Apollo Funds and Riverstone Funds. The interests of Apollo Funds and Riverstone Funds may differ from the interests of our other stockholders…. Through their ownership of a majority of our voting power and the provisions set forth in our charter, bylaws and the Stockholders’ Agreement, the Apollo Funds and the Riverstone Funds have the ability to designate and elect a majority of our directors.”

In 2018, Talos bought a troubled company that was heavily indebted to Apollo; as a result of this purchase, Apollo was nearly made whole on an investment that might otherwise have failed.  Then, in 2019, Talos bought certain assets from Riverstone, and it was this purchase that was alleged by a derivative plaintiff to have been unfair to the public stockholders.

When the Riverstone transaction was arranged, Riverstone’s 2 board nominees, both of whom were also Riverstone affiliates, were recused from the negotiation process. Additionally, one of Apollo’s nominees was recused, because of her associations with Riverstone.  So that left 7 directors to arrange the transaction, including the joint Riverstone-Apollo nominee, one Apollo nominee who was also an Apollo affiliate, and the CEO.  A representative of Riverstone and one of Apollo observed all Board meetings on the subject, without apparently speaking.  Under the original terms of the deal, Talos was supposed to pay for the Riverstone assets partially in common stock, but that issuance would have required approval of the common stockholders; as a result, the terms of the deal were changed so that Talos paid in a new form of preferred stock that would automatically convert to common.  The change was approved by Apollo and Riverstone in a written consent, the result of which was to avoid a shareholder vote and allow the deal to close more quickly. Per the court, “There was no Board meeting discussing, or resolution approving, the changing of these terms.”

The derivative plaintiff claimed that Talos overpaid for the Riverstone assets.  He argued that Apollo and Riverstone were controlling shareholders of Talos and had a kind of quid pro quo arrangement whereby each one would approve the other’s tainted deal.  Because Apollo and Riverstone together were controllers, the argument went, the two had fiduciary duties to Talos and the Riverstone deal was subject to entire fairness review. 

Vice Chancellor Zurn, however, rejected the argument that Apollo and Riverstone were bound together in a manner that would constitute a control group.   First, she looked at general ties between the two.  She disagreed that there was any significant historical relationship between the parties as had been found in other cases involving putative joint controllers, like In re Hansen Medical Shareholders Litigation, 2018 WL 3025525 (Del. Ch. June 18, 2018), and Garfield v. BlackRock Mortgage Ventures, 2019 WL 7168004 (Del. Ch. Dec. 20, 2019), such as a pattern of joint investments.  She also felt that the admission of controlled status under NYSE rules was “not as strong” as self-designations of controller status in Hansen and Garfield; for example in Hansen, the two funds had admitted to working as a group in a 13D filing pertaining to a different company.

Second, she looked to transaction-specific ties.  She found no evidence for the purported quid pro quo other than the mere fact that the two transactions had taken place.  The shareholders’ agreement was no evidence of such an arrangement, because it only referred to director voting and did not make any promises regarding votes on other matters.  And the presence of Riverstone and Apollo representatives as observers in board meetings did not suggest any specific involvement in negotiations.

Thus, she concluded that Apollo and Riverstone were not sufficiently associated that their separate minority positions should be linked.  Given that, in their role as individual minority shareholders, they had no fiduciary duties to Talos that they could violate. The transaction with Riverstone was not subject to entire fairness review because Riverstone was not a controlling shareholder – or even a fiduciary – of Talos.

The problem I have with all of this starts with the standard announced by the Delaware Supreme Court in Sheldon v. Pinto Tech. Ventures, L.P., 220 A.3d 245 (Del. 2019).  According to that case, a controller exists “where the stockholder (1) owns more than 50% of the voting power of a corporation or (2) owns less than 50% of the voting power of the corporation but exercises control over the business affairs of the corporation.… [M]ultiple stockholders together can constitute a control group exercising majority or effective control, with each member subject to the fiduciary duties of a controller. To demonstrate that a group of stockholders exercises control collectively, the [plaintiffs] must establish that they are connected in some legally significant way—such as by contract, common ownership, agreement, or other arrangement—to work together toward a shared goal.” 

Relying on cases like Garfield and Hansen, VC Zurn looked to the factors those courts had examined (transaction-specific ties, historical ties) to conclude that the Sheldon standard was not met.  But in Garfield and Hansen, the courts were trying to determine whether an agreement actually existed in the first place.  Here, it was not necessary to try to suss out whether there was an agreement, because Apollo and Riverstone admitted they had one.  All that was necessary was to determine whether the agreement they had gave them “more than 50% of the voting power of a corporation...exercising majority or effective control.”

Under the agreement they admitted to having, Apollo and Riverstone jointly had more than 50% of the vote, and they jointly agreed that they would use that voting power to select 6 members of a 10 member board.  Sure, they divvied it up – you vote for my nominee, I’ll vote for yours – but the fact remains, they had a “legally significant connection” – an actual, for real, disclosed contract – for dictating 60% of the directors.  Four of whom actually worked for Riverstone or Apollo; one of whom was the Talos CEO.  (Not that those ties matter, necessarily; imagine a single stockholder, with more than 50% of the vote, who nonetheless chose to select only nominally independent board members. That entity would absolutely be a controller.[1]  Therefore, it shouldn’t matter who Apollo and Riverstone chose to place on the board – the relevant point is that with more than 50% of the vote, they had an agreement to jointly select more than half the board members). 

True, their agreement did not give them transactional control over the particular purchase in question, but usually transactional control is treated as an alternative test for controller status; controller status also exists when someone controls the corporation in general.  See, e.g., In re Rouse Props., Inc., 2018 WL 1226015 (Del. Ch. Mar. 9, 2018).  And when it came to the corporation in general, Apollo and Riverstone straightforwardly, together, had “more than 50% of the voting power of a corporation,” and therefore “constitute[d] a control group exercising majority or effective control,” with all the legal consequences that follow.  The rest of it – their history, their involvement with the negotiations, the existence (or not) of a quid pro quo – is beside the point.

(Also, for what it’s worth, if you’re looking for evidence that they jointly executed the transaction, the fact that Apollo and Riverstone somehow changed the deal terms all on their own without involving the Board seems pretty significant.)

Anyway, all of this matters because, as scholars are now documenting, shareholder agreements in public companies are increasingly common, usually involving PE firms like Apollo and Riverstone.  They often provide for board seats, observation rights, and positions on key committees, among other things.  So it’s really, really important that courts come to a coherent, consistent position on how these agreements will be addressed, and as relevant here, when transactional control is going to be a necessary aspect of the controlling shareholder inquiry.

 

[1] For example, ViacomCBS has a majority independent board but – well, you know.